Surprise! Full convertibility is on its way

The RBI’s executive director, G Padmanabhan, is the latest to express the view that India’s move towards capital account convertibility (CAC) is inevitable. This follows similar statements expressed by the minister of state for finance, Jayant Sinha, as well as the governor, Raghuram Rajan.

These views surprised many, given the fragile corporate balance sheets, the state of Indian banks, the vulnerability of the currency and the external sector once US starts hiking interest rates, and the threat of black money. While there is no denying that these factors will impede a move towards full CAC in the next couple of years, the RBI and the finance ministry are laying the ground for the long term.

Over the last few years, the building blocks for full CAC have been put in place.

Rules governing exchange traded currency derivatives have been tweaked to encourage greater participation, interest rate futures and offshore rupee bonds have been issued, and an offshore financial centre will soon be set up in the country. It is obvious that the RBI governor knows what he wants. Even in his first speech, Rajan had talked about “internationalisation of the Indian rupee” as one of his goals.

The reason why the RBI and the finance ministry are pitching for currency convertibility is not difficult to see. India is expected to record among the fastest rates of economic growth in the next two decades. According to data put out by the US department of agriculture, India will be the third largest economy by 2030, at $6.6 trillion, after the US and China. When a country is gearing up for this, full CAC will be one of the driving factors. But we are still years away from complete CAC. So what are the pre-conditions for this change?

Internationalisation of the rupee : Most economies with full CAC have currencies that are used internationally to trade and settle monetary transactions, held not just by residents of the country but by citizens of other nations too.

Internationalisation wards off a steep sell-off in a currency since it is held widely and investors would not want the value of their holding to erode. For instance, China is one of the largest holders of US treasury securities. So China would think twice about dumping dollars, even if it expects the dollar to depreciate, as it would affect the value of its holding of US treasury securities. It is only in the last few years that the rupee is becoming more acceptable as a medium of exchange in transactions involving residents. Making other nationals use the rupee as a medium of exchange will, therefore, take time.

Setting up an IFC : The development of an offshore financial centre helps a currency move towards internationalisation faster. As global companies and investors set up shop in offshore financial centres located within the country, their familiarity and comfort level with the country increases, making them more willing to use it as a medium of exchange. The government has set the ball rolling on this front with the GIFT city being set up in Gujarat. But it will take at least five years before it achieves the scales of other successful IFCs such as Hong Kong or Dubai.

Overseas market for rupee bonds : Rupee bonds issued overseas will also help increase the holding of rupee-linked or rupee-denominated instruments in the hands of overseas investors.

The RBI has taken the first step in setting up this market by allowing Indian companies to raise offshore rupee bonds. Indian Railways has been among the first to queue up. The International Finance Corporation issued ‘Masala Bonds’ in November 2014 that are linked to the rupee but settled in dollars.

A strong derivative market : The exchange traded currency derivative market has been around since 2008 but it has not grown to a desirable extent thanks to undue restriction on trading in this segment.

A knee-jerk reaction to the currency crisis in 2013, with an increase in trading margins and limiting participation of banks, also dealt a blow to this segment. The RBI has recently allowed FPIs to trade to a limited extent in this segment. The interest rate derivate futures market too is in its nascent stages and will take a few years to really grow and meet its desired objective of acting as an instrument for hedging risk.

Besides these, the black money angle needs to be given considerable attention. CAC will give citizens the freedom to convert their assets to foreign assets at will.

This will be a freeway for money launderers.

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